7/13/2009 @ 6:00AM

Transcript: P. Brett Hammond

Hello, I’m Steve Forbes. It’s a privilege to introduce you to our featured guest, Brett Hammond. Brett is the chief investment strategist for TIAA-CREF Asset Management, one of the world’s largest pension funds. As such, he has to ensure steady payments to firm members even when the markets don’t cooperate. How does he do it?

My conversation with Brett Hammond follows, but first–

As we endure the most serious financial crisis since the Great Depression, we need strong, wise leadership to lead us out. But I fear that President Obama is drawing the wrong lessons from history and making moves that will only prolong this problem.

Though he remains popular, Obama’s actions remind me of those from another leader from history: Julius Caesar. Though Obama seems to have a cool temperament, he has not restrained himself anywhere. Whether it’s unionization, cap and trade, raising taxes or nationalizing health care, he has pushed them all.

Like Caesar, Obama’s struck while the iron’s hot. Unfortunately this meant allying himself with Nancy Pelosi–who may yet prove his Brutus. Her spending programs, which Obama signed in one of his first acts as president, add up to at least $800 billion. Where is this money going to come from? You and me. And that means less money for his cherished health care proposals.

Like Caesar, Obama risks dividing the republic if he pushes too far. Already there are signs of blowback from his rampant spending and disguised taxes. But he best beware the ides of March. I predict revolution in 2010.

In a moment, my conversation with Brett Hammond.

Income In Retirement

Steve Forbes: Thank you very much, Brett, for joining us. You made a very subtle point, and I hope you can explain it to our viewers. And that is, you make the distinction on something like a 401(k), we tend to think of wealth creation but you make the distinction that a 401(k) should be thought of as an income producer. You have other portfolios for wealth creation; but this is to produce a stream of income, which means a different set of investment objectives than we’ve been normally accustomed to.

Brett Hammond: Absolutely right. There’s nothing wrong with wealth creation. In fact, it’s fabulous. But the problem is if you’re only thinking about wealth creation for retirement income, you may forget about all the other things you need to take into account. Such as, “How do you take that income? What are you really building this for? Are you building it in order to hang onto it?” If so, you may be so reluctant to take money out of it, you’re really going to starve yourself in retirement.

Forbes: Now how does that get distinguished from, people say, “Well, with my retirement nest egg, I’m only going to withdraw 4 or 5% a year,” instead of thinking of annuity? So you don’t depend on the portfolio; at least part of your retirement, you have fixed.

Hammond: This is the key. If you start thinking about, there’s actually a wonderful study that was done by Jeff Brown, at the University of Illinois, where he asked sets of people to tell him what kind of retirement product they would want to buy. But he presented the options, the identical options, in two different sets of language.

The first language was, “You have, let’s say, $600,000 in wealth. You’ve got those assets. What are you going to do with them?” And when he presented it in that kind of language, only 20% of the people took the annuity option. Most of them took the 4 to 5% withdrawal; but it was identical economically.

However, when they went to another group of people and said, “This is an income. You’re going to produce some income. This money is support income,” they kept talking in income terms, 70% of the people took the annuity. This is just remarkable. And I think it goes right along with what you say: If you present these things to people as the opportunity to create an income floor, something that, along with social security, they can’t run out of, and that’s a lifetime annuity, then they can take the rest of their money and use it as kind of wealth, either to pass along to the kids or use themselves.

Forbes: Now, a couple of things on that. First of all, how do you get people to recognize that retirement is income; it’s not just assets?

Hammond: Well, I think this is one of the fundamental things about the 401(k) model. At TIAA-CREF, what we constantly talk about is, “You’re creating retirement income.” Whereas, I think, in the 401(k) model, the tradition has been, “You’re building a nest egg.” What’s it for? Well, it might be for retirement. But is it for income? “Well, we’re not really going to talk about that.” So you’ve really got to constantly educate people about this.

Forbes: And in the whole thing on a 401(k), do you think it’s an adequate way to save for retirement? Or are we just confusing fish and fowl? That you have, as I said, a portfolio for wealth creation; and you have another portfolio which should be the 401(k), where you’re focused on getting that retirement income?

Hammond: I fully agree that you’ve got to differentiate what the purpose is. Yeah, it’s all green money. But you also have to think about, “Do you have more than one goal?” And the 401(k) is not a bad idea. It’s just that it needs to be re-thought in the sense of, are the contribution rates high enough? Are people using the money wisely in terms of asset allocation and rebalancing? And are they thinking about it as a retirement income producer, rather than just a pot of money that they want to hoard?

Age Into Fixed Annuities

Forbes: Right. Now, on the whole thing on annuities. When I was growing up, it was a fixed annuity; then we got variable annuities. Is a variable annuity sort of a contradiction in terms? Or is this kind of a product, along with the 401(k), which you think of, at a certain age, it becomes more fixed rather than variable?

Hammond: Well, this is good. You know, interestingly, TIAA-CREF, certainly not in my generation, but the generation of TIAA-CREF employees in the ’50s invented the variable annuity in the first place. And it was done because, with fixed annuities in a high inflationary environment after World War II, the fixed annuities just weren’t making it. So, you know, the attempt there was to find something that would produce, over the long run, something more than inflation but, albeit, with some risk. So what is the place of variable annuities? I think what people need to see variable annuities as doing is providing an income that will never run out. That’s great. That’s the annuity part. But it’s variable; and therefore, you’re taking risk, if it’s in a stock fund, a bond fund, etc.

So what we say is you need an asset allocation that diversifies your risk even in retirement. So that you have a fixed annuity that, along with social security, may provide that rock solid base for your income. And then, the variable annuity to give you a chance of continuing to accumulate as you go through the retirement years.

Forbes: And that then almost begs the question that since, as we’ve seen, markets are variable; markets are choppy, should there be almost, not a law, obviously, but a real understanding that, as you get older, more and more of this should be going in the fixed account rather than the variable account?

Hammond: I think this is critical. You know, what we, at TIAA-CREF, have kind of come up with are the three A’s for thinking about retirement income. The first, of course, is “auto enrollment,” where people–

Autopilot 401(k)s

Forbes: This gets to the whole thing on reforming 401(k)s, which was sort of a hybrid that, “We had one mindset, but it’s really we’ve got to get a different mindset.”

Hammond: Absolutely. I mean, 401(k)s are great in the sense that they leave the choice up to the individual. But what we’ve got to remember is that most individuals are not certain about what those choices should be. So, for example, if you have auto enrollment, that doesn’t mean you have to enroll; it just means you defaulted into enrolling.

Forbes: Sort of like the old book clubs.

Hammond: Exactly.

Forbes: You got the book unless you said no.

Hammond: That’s right. And the second “A” is “advice.” And that goes with kind of what you’re saying. Because what do you do at any one point in your life? When you initially put some money aside, how do allocate that? Very few of us are experts. So if you get some advice from a trusted source, a life cycle fund or an individual adviser, that can help you figure out what’s the right allocation for you. And, over time, if you go back for that advice, that can help you figure out what should you do over the long run to make your portfolio safe as you get older, just as you suggested. Of course, the last one, you can guess: the “A” is “annuities.” Not that you should annuitize everything. But you need a base for setting a solid foundation for your income.

Forbes: Now, the way 401(k)s are set up today, you talked about the need for auto enrollment, you also talked about, perhaps, an auto contribution rate as well as part of the reform.

Hammond: Yeah. I think if you default people into a contribution rate, whether there’s employer match or not, whatever it is, one of the problems with the 401(k) is that the average contribution rates, we know this, are 6 to 8%. We also know that’s not enough.

We’ve done studies at TIAA-CREF on our participants and, between the employers and the employees, the mandatory contributions and the say, supplemental contributions, the average TIAA-CREF participant contributes 17% of their income. So we know that that works. We’re very certain that 6-8% doesn’t work. So if you have an auto contribution that you can always get out of if there’s an emergency, I think that lays a better groundwork.

TooMany Choices

Forbes: Now, in terms of the 401(k) today, one of the things you’ve mentioned in the past, is that the there are too many choices. It’s almost like picking, “What fund do you want?” and we’ve got thousands of them out there. And even with the choices now, I know, when we had our own thrift plan years ago, you had the bond fund, the stock fund and the mix of the two. Now you’ve got a whole slew of funds no matter who you go with; there are a lot of choices out there. Should there be almost a mandatory emphasis that, at a certain age, you have to start thinking about life cycle funds? Or something that gets you geared where, like auto enrollment, “This is going to happen unless you say no”?

Hammond: Absolutely. I mean, I think this goes right along with our three A’s, which is, as part of that advice, what you may want to do is default people who don’t want to make a choice into something like a lifecycle fund. Not a fancy one; something pretty conservative in the sense of, you know, not a lot of exotic asset classes necessarily. But something that’s going to stand them in good stead for the long run. And if they’re an expert, or they want to rely on expertise, they can make changes in that allocation. But defaulting them into a life cycle fund makes a huge difference. Just to go back to your point about the fund choice, absolutely there are too many choices out there. The research has shown that for every ten funds you add in a retirement plan, 3% more people don’t make any choice at all.

Forbes: So that it just overwhelms them?

Hammond: It just overwhelms them.

GettingGood Advice

Forbes: What stands in the way of advice? Weren’t there reforms made a few years ago where companies wouldn’t suddenly find themselves deluged with lawsuits if they allowed people to offer advice? Is it just inertia? Why haven’t we made more progress on this? Or do we need a bear market to remind us we do need to do more than just do it and hope for the best?

Hammond: Well, there does seem to be a herd mentality. But, you know, chase the returns, we all know that. Hopefully, advice is something that we used to help prevent that or ameliorate it. But there’s also absolutely the inertia problem. We know that the majority of people who put their money in a retirement fund, a defined contribution plan, never make a change once they’ve set the initial contribution rate. So there’s tremendous inertia. We all, in the industry, need to reach out to people and say, “We think you should have some advice. Would you like it? And here it is.” We offer advice to our three million participants and we don’t charge for it because we believe that that’s so important to do.

We also, when we give advice, we turn to an outside provider of asset allocation recommendations, as well as fund selection. Because we want to be able to go to our participants and say, “We don’t have skin in this game. There’s an independent third party that’s telling you the allocation model to use,” for example. So we think that that would work. It’s the kind of model that really should be applied more broadly, we believe.

Forbes: And how do you choose these outside advisers?

Hammond: Well, exactly what do we do? Well, we went through a huge process in the early part of this decade, where we looked at every possible provider of outside advice and held a competition. And the criteria, in essence, were, “What is your model? How truly independent are you?” So we wanted to make sure that if we tried to influence them, they’d say, “No. You may be the client, but you’re not telling us what to do.” And so, we’re very happy with the choices that we’ve made.

Stock Picking Works

Forbes: Now, and going beyond the 401(k)s and annuities, you also advise people, getting to the portfolio side, non-retirement side “Pick stocks individually. Don’t necessarily go by sectors.” Where others say, “You get the sector right, it doesn’t really matter. Blah, blah, blah.” You almost sound like something we grew up with: “Pick stocks individually. None of this sophisticated stuff.”

Hammond: Yeah. Well, you might say that that’s both the least sophisticated and the most sophisticated thing you could be doing. We feel very strongly that sector and region and, you know, some of the big choices, that the folks who do that, you know, more power to ‘em. But we feel that we get that right some of the time, and we get it really wrong some of the time. So should we have been able to make the call on exactly when to get into the auto industry? And when to get out? We’re not in that business. We’re in the business of saying, “Which of the auto makers is the one that we think is going to do better than the others?” And that is a matter of fundamental, bottom-up research that has stood in good stead for decades, just as you say.

Forbes: So could you have, then, a theoretical portfolio that is top-heavy in certain sectors? And is that a good thing, even though we can say each of these stocks, you know, meets good criteria, good fundamentals?

Hammond: Well, in our quantitative portfolios and in our fundamental active portfolios, we do as much as we can to neutralize sector and region, you know, some of the big factors. So what we’ll do is say, “Pick the best auto stock” or, “Maybe there’s two or three,” but we won’t let the portfolio manager dump everything into auto stocks; or everything out of auto stocks. You’ve got to be in the sector. So what we’re doing is saying, “Be relatively market weight in each sector. But pick the best companies within that sector.”

FocusOn Management

Forbes: Now, another thing you do that is harder to do, it would seem, is focus on management. Try to figure out how a company picks its management. Could you explain a little bit of that? You’ve mentioned in the past, Eaton,
P&G
, obviously, GE, everyone cites that one,
IBM
in the old days.

Hammond: Absolutely. These are, you know, what you go back to. Is some of the analysis that got done by Jim Collins, for example, in his very good books on what makes a good company. And it isn’t just the balance sheet. It’s obviously the intangibles that you have to do deep research on. I mean, I’ll pick another example in addition to the ones that you mentioned. But one of the things that we went through a few years ago, and I’m just somehow sticking to the auto industry today, but it was
Nissan
.

Forbes: Abject lesson.

Hammond: Yeah, exactly. It was Nissan. And the fellow named Ghosin, who was from Europe. Right? And so, our auto analyst started pounding the table, saying, “Ghosin is going to Nissan. We’ve got to buy Nissan.” And everybody said, “No. You’re just in love with Ghosin. You know, you’ve been so caught up with him that you can’t see straight.”

Forbes: Sort of a groupie.

Hammond: Exactly. And he said, “No. Look at the fundamentals, look at the balance sheet, look at Nissan and then you add this intangible of Ghosin and it’s going to work. Just it’s going to work.” And huge amounts of discussions. We went in that direction and we were very happy that we did.

Now, you don’t always make calls on the superstar. There are times when you say, “The company’s great. You know, you don’t want to bet on the management. But the company will do OK anyway.” So you’re not just looking for superstars, but you want to take that into account.

Forbes: Do you also take into account systems inside, as much as you can get a feel for management systems in terms of creating talent?

Hammond: Absolutely.

Forbes: And how does an individual investor do it? It must be hard enough for an institutional investor to try to get in the innards of these things.

Hammond: Well, take a look. Where have the CEOs come from? Have they all been from–you know, Ghosin was a wonderful example of a CEO coming in from the outside and revitalizing Nissan. But, for the most part, one of the indicators is, “Do they grow CEOs and senior management from the inside?” You know, you may need an outsider from time to time, but the true value of a management, you know, sort of development system is, “Are you producing the kind of people who can either take over the CEO, take over the senior vice president’s or go to another company because they’re so good?” I think that’s one of the key indicators.

Growing A CEO

Forbes: And what are some of the signposts? What are some of the things you look for that they have an internal farm system, you might say, that is working? Is it the number who go outside? Or how would you say realize that a P&G would pick somebody like Lafley that would revitalize the company?

Hammond: Well, the first step, I think, is to ask, “Where are you getting your senior management? Are they being grown from the inside?” Now, if they’re being grown from the inside and the company hasn’t shown a profit for five years, there’s one story. But if the company is doing pretty well, and you see that the senior management team has really come up from the inside, you can then go and ask, “Well, can we find out what their training programs look like?” But at least you have an indicator that they’re making an effort to really get people experienced and get them all the way up the ladder.

Forbes: And what are some, looking at that, that still impress you these days? Now, let’s just focus on GE. That was once held up for the example. Even if you didn’t make it to the top, everyone wanted the talent. And you could always get a great job elsewhere. Has that myth been, not myth, but that image been shattered by what both has happened to GE and poor Bob Nardelli? Or–

Hammond: To say
Home Depot
.

Forbes: Well, yeah. Chrysler.

Hammond: Yeah.

Forbes: Or what? Or is the fact that GE is going to be survivor shows the system works even in adversity?

Hammond: I think I’d pick the latter. GE has still got one of the best training programs and management development programs there is. You know, if Jack Welch had taken over GE three years ago, it’s not clear that Jack Welch would have done any better than Immelt has done.

Forbes: Right. Right.

Hammond: I think what we’ve all got to take into account is the environment. And we know the environment has just been much more challenging in the last few years than it ever was for the two decades before that. So I still think GE, you look at
Nordstrom
, you look at some of the really long-standing, great companies that grow from within,
Wal-Mart
, very similar.

Forbes: Right. Looking at the macro, is the worst over in terms of both the markets and then the economy? Or have we still got some roller coasters to come?

Hammond: Boy, we’d sure like to think so. The way I see it is we’ve run out of letters to describe what the economy is going to do. You know, we–

Forbes: It’s a great alphabet teacher. I never heard of so many U’s and W’s and L’s and extended L’s.

Hammond: So where I’ve kind of gone with this is either a swimming pool or a bathtub. You know, where it goes down and then sort of gradually comes back up again? I’m afraid that that’s maybe where we are. It may be that we’re around the drain hole at the moment; but maybe we’re taking a few steps away. And I think that what we’re going to see–

Forbes: So we’re going to be shivering awhile before–

Hammond: We’re going to shivering awhile and it’s going to take a long time.

Forbes: Just because of the amount of indebtedness, misallocation, of all of the above?

Hammond: Well, we haven’t finished de-leveraging. You know, there’s plenty of that still out there to do. We have created, in essence, a $3 trillion hole in just the U.S. economy. And the numbers really aren’t in on the global economy yet. We’ve just been seeing that the global economy’s probably going to drop three percent this year; worst performance since World War II. So it’s a ways to go. We’ve got to climb out.

Stay Alert

Forbes: And so, what do you think this market has taught us about risk? Can’t get rid of it?

Hammond: Well, don’t fall asleep. I think that’s what the market has really taught us, is don’t fall asleep. You know, in the ’90s, we all got lulled. And, you know, very few, there are people who can claim that they got out, you know, in the right time. Was it luck? Or was it prescience? Well, I’ll leave it to your viewers to decide.

But we did it again. Starting, you know, after the meltdown in 2000 and 2001. We all got complacent again. And then it was worse, because we got complacent about housing. Or even overeager about all of that stuff. So what do you do? I think what you do is you really want to stick to, “What are the fundamentals here? What are the PEs? Forward and backward-looking, top-down, not just bottom-up. Really try and pay attention to the fundamentals.” Because they’ll help tell you that the market is potentially overvalued or that the housing market has gone beyond where it should.

Forbes: A final thing on that: credit rating agencies. Does that whole model have to be changed? Where, instead of laws in effect saying, “It’s got to be triple-A,” and you only have a handful doing it, do we have to get back to a system where you pick a lot of analysts. Just as in stocks; companies don’t pay analysts to do an opinion of what the company stock should be. People would say, “No, you wouldn’t do that.” Yet, that’s what we do with the debt. Do we have to change the model, do you think?

Hammond: It’s a very interesting idea you raise about the equity model, research model and credit. Well, it’s clear that the credit agencies just failed to do what, in retrospect, they should have done. And it may be that, you know, well-meaning, you know, sincere efforts, but something went truly wrong. And so, what do you do? It seems to me that what’s interesting about the Obama administration’s proposals there is that they didn’t go very far. You know they really said, “Just let’s pull up our socks and do it better.” What they didn’t address–

Forbes: “Try harder next time.”

Hammond: Yeah, exactly. And what they didn’t address is, “Is there a fundamental conflict of interest in the way credit agencies get paid?” You know, as you say, at least these days, the equity researchers are not put in the kind of conflict that they might have been in a few years ago.

Forbes: Right.

Hammond: And so, their independence seems a lot stronger than that of the credit agencies. Fundamental, you know, “How do you get paid?” And second, “Are you devoting enough resources to it?” You know, “Are you really able to look under the hood, deep down in the engine of a company, to figure out what that credit is going to do?” And, “Are we putting enough effort into new instruments?” There’s going to be not just the instruments that we got in trouble with already; but we’ll invent more, as time goes on. And so, “Are they capable of dealing with that kind of change?” And the answer, I think, could be a bit troubling. But we’ll have to see what happens with the credit agencies because I think they’re taking this very seriously, and they do want to pull up their socks. We just have to see if they’re able to.

Forbes: And finally, what’s your bold prediction for the future, seeing what you’ve seen, and seeing what you’ve seen in the last couple of years?

Hammond: Well, it’s interesting. You know, we could talk about the economy; we could talk about this or that. The bold prediction for the future could be a new standard, the Euro; and the dollar becomes just another currency. So I think we’ve got to watch for that. Are we seeing a gradual transition where, at some point, the world sits down and says, “Wait. It’s really de facto, the Euro, now anyway. So let’s go for the Euro.” I don’t think it’s going to work what Russia is proposing, which is this basket of currencies. You know, we could figure that out, but it’s just too complicated for the common person, the common investor. I think it may be the Euro.

Forbes: So the poor dollar is going to go the way of the Argentine peso?

Hammond: Well, the Argentine peso may go the way of the dollar, since it’s linked.